Ways to Invest: Exchanges, Indexes, and ETFs
To understand investing outside of single companies, we can look at different ways the market is divided up. First, up is a stock exchange. An exchange is a marketplace where securities (like stocks and bonds), commodities (like wheat and oil), and other financial instruments (like derivatives) are traded. The core function of an exchange is to ensure fair and orderly trading and the efficient spread of price information for any securities trading on that exchange. Exchanges give companies, governments, and other groups a platform from which to sell securities to the investing public. Some examples of exchanges include the New York Stock Exchange (NYSE) and the NASDAQ. You may be familiar with the chaotic “trading floors” of a stock exchange. Though some orders may be processed in a physical location like the NYSE, the great majority of trades are completed through electronic means without regard to a physical location.
Fun Facts about the NYSE
A company must have at least $4 million in shareholder's equity to be listed on the New York Stock Exchange.
More than 80% of trading on the New York Stock Exchange is done electronically.
The New York Stock Exchange has been around since 1792.
Fun Facts about the NASDAQ
Most of the world's technology giants are listed on the Nasdaq.
Its name was originally an acronym for "National Association of Securities Dealers Automated Quotations"
Nasdaq opened for business on Feb. 8, 1971
Now that we’ve gone over exchanges, we can further divide the market by looking at indexes. An index is a method to track the performance of a group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market. These could capture the entire market, such as the Standard & Poor's 500 Index or Dow Jones Industrial Average (DJIA), or more specialized such as indexes that track a particular industry or segment. For example, you may hear people ask the question “How’d the market do today?” This question can be answered using indexes such as the S&P 500 (ticker symbol $SPX) or the NASDAQ Composite Index (ticker symbol $IXIC).
Many indexes are used as benchmarks to measure the performance of other investing styles. For example, if a fund manager claims to have “beaten the market” they are probably referring to a return that exceeded that of the S&P 500 index. Many investors choose a style of investment known as “passive investing.” This style of investing looks to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon. This strategy often outperforms many actively managed strategies where securities are bought and sold more frequently and require management fees. Indexes such as the S&P 500 also contain exposure to a large diversity of companies, thus minimizing the risk when compared to investing in only one company or sector.
Lastly, an exchange-traded fund (or ETF) is an investment fund that trades like a stock. These investments pool together money from investors into a “basket” of different investments including stocks, bonds, foreign securities, currencies, or commodities. Therefore, you can gain a stake in a large variety of companies without buying individual shares of every company. By spreading money through various securities, ETFs can generally provide investors with diversification which can help balance risks. These securities can be bought and sold like stocks but sometimes contain commissions and related fees. Some ETFs invest in a variety of stocks, some replicate the performance of the entire market, and others replicate the performance of a specific sector (technology, pharmaceuticals, etc). Here, we can see that ETFs offer different ranges of diversification. Clearly, ETFs that represent the entire S&P offer more diversification (and generally less risk) than ETFs that represent a specific sector or smaller group of companies. After investing in an ETF, they function very similarly to stocks: some have dividend yields, increase/decrease price, and can be traded throughout the trading day. ETFs can save investors on research and analysis time, cash needed to invest in a large number of companies, and management fees when compared to mutual funds.
Discussion Topics:
Passive Investing
Active Investing
“Beating” the market
Risk Reward
Diversification
Mutual Funds
Sources:
*All rights of content are reserved to the TD Ameritrade Education Center*
“What is Index Investing?” Investopedia, investopedia.com/terms/s/stock.asp
https://www.investopedia.com/terms/i/index-investing.asp
*Disclosure: These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. Please consult your financial or tax professional prior to making an investment.